How Does Escalating Compensation Fit in With Today's Firm Economics?

by Joel A. Rose

In a recent article in The Legal Intelligencer, it was reported that the Washington, D.C., law firm of Williams & Connolly, one of the premier litigation firms in the country, may raise its pay for starting associates to $180,000, which is about $20,000 above the market rate in most major U.S. law firms, with a $15,000 to $25,000 boost for its other associate classes.

Since the conventional wisdom is that select New York City firms would undoubtedly increase their starting salaries above $180,000, what would be the effects of the "trickle down theory" of this higher associate compensation on the economics of other large and midsized law firms? In other words, how does this escalating associate compensation fit in with today's law firm economics?

The short answer is that it doesn't when one considers that the associate cash compensation package is comprised of four basic components: a base salary (structured to class standing in the larger law firms); a bonus payment structured on one or more of the following: legal merit, contributions to firm profitability, firm economics and the origination of business; a profit-sharing plan based upon the firm's success; and a reasonably comprehensive benefits program.

The traditional associate cash compensation package is a major factor of firm expense over which many law firms have limited control because of the competitive nature of the current compensation market.

Until a few of the large Philadelphia-based law firms recently announced that they were increasing the starting salaries offered to recent law school graduates so that these firms may position themselves to recruit the best and the brightest law school graduates, the trend of the salaries paid to law school graduates had leveled off to some extent.

Even though the Philadelphia cost of living may be lower than in other major cities, the compensation paid to associates by larger Philadelphia-based law firms has to be competitive. Associates in larger Philadelphia firms work closely with attorneys in law firms in New York, Los Angeles and other major cities. The work performed by associates in the Philadelphia-based firms is as challenging and sophisticated as it is in any major city. Hence, the compensation paid to associates by larger Philadelphia firms that recruit top legal talent from the nation's best law schools, and seek to attract and retain top quality talent, must remain competitive.

Years ago, the basic rules affecting the compensation of associates were inexorably tied to their hourly billing rates times the number of hours they worked. The billing rate was set by doubling the associate's salary and dropping three digits. For example, when starting salaries for law school graduates were $50,000, ($50,000 times two equals $100,000, which equals a $100 billing rate.) At 1,500 hours, one-third of an associate's earnings would be salary, one-third would be to contribute to overhead and one-third would be profit (1,500 times $100 equals $150,000 divided by three, which equals $50,000).

During the boom periods of recent years, clients were willing to pay for the thorough staffing of matters, and to a lesser extent for the training of those newer associates assigned to work on their files. However, today's higher associate compensation levels have exceeded possible hourly rate increases that may be passed on to clients. As a result, the independence of associate compensation from the hourly rates charged to clients demonstrates the dynamics of two distinct and important markets at work. One market is based upon how much law firms have to pay to attract and retain top-quality law school graduates, which is affected by the associate legal employment market as a whole. The second is the unwillingness of clients to pay associates' high hourly rates that paid for their total compensation. As a result, an increasing portion of the associate compensation levels are now absorbed by the firm and are reflected as lower profits for the partners.

During discussions with managing partners of mid-size (35 to 60 attorneys) firms and larger (100-plus attorneys) law firms about the compression in associate compensation resulting from the higher starting salaries offered to recent law school graduates, most of these partners acknowledged that their firms have little choice but to raise their firms' starting salaries to some extent, to attract and retain higher quality associates. More than a few of them eschewed the higher compensation levels for a variety of reasons.

Most acknowledged that during the first two or three years with the firm, while in training to learn how to practice law, the great majority of associates are not worth the current market price, especially since the higher salaries do not reflect write-offs/downs, volume discounts and other billing arrangements that reduce the level of firm revenue and profitability and effectively increase the costs of associates. A few of these partners opined that with increasing overhead outpacing billing rates and revenue, it takes a firm at least two or three years before starting associates begin to contribute to firm profit. Also, several partners indicated that meeting the higher new associate compensation levels forces their firms to make compensation changes all the way up the associate compensation schedule.

It has been my experience that partners in many midsized and larger law firms have and will continue to reassess their current methodology for compensating associates and their billing and collection practices in an effort to develop creative strategies to cope with the higher associate compensation market rates. Some of the strategies that have been implemented include the following:

Develop and implement merit-driven systems rather than lockstep "class" salary increases.

More law firms are seeking to achieve a level of greater flexibility with their associate compensation system to enable the associates to be compensated consistent with their contribution to firm economics. Several of these firms are in the process of converting the current methodology for granting associate increases from lockstep (by class for the first several years) to a meritocracy.

Changes are also being considered on the organizational side to administer associate compensation programs. For example, for increases to associates' compensation, more firms are providing to the heads of their substantive departments and practice groups budgets for salary increases, which may be a percentage of current associate salaries.

This budget represents for that practice area or group the available pool of dollars from which the department/group heads may allocate increases. In this fashion, the firm can control its budget and the percent of associate salary expense relative to revenue and total expenses. Also, since these partners are most knowledgeable about associate performance, they are the most appropriate ones to award merit increases.

This avoids lockstep and predictable increases to all of the associates within a class, etc. Although there is debate on the issue, across the board increases are considered to be demoralizing and seem to have a disincentive effect because associates think that the firm is not giving them individual consideration.

Firms are hiring lateral associates.

First-year associates require more training time that is nonbillable and as such, reduces the productivity of the partners involved. Hence, for many midsized and some larger law firms, the trend is toward reliance on hiring lateral associates who are already trained. With adequate lead-time, by employing lateral associates, these firms are able to fill their professional staffing requirements at, or shortly before, the time they occur. By hiring trained laterals, these firms may bill clients at hourly rates that allow immediate or short-term payback and contribution to firm profit.

Firms are hiring temporary lawyers to lower fees.

Temporary lawyers are one response to client pressures for lower fees. In today's booming litigation environment, many firms are engaging temporary lawyers to satisfy document intensive demands. For example, meeting different discovery requests to a single client in several different courts; discovery in litigation is the area most likely to benefit since discovery is an area of litigation that incur the highest costs. Also, the economic benefits are clear as a firm may charge lower hourly fees for a temporary associate with the same level of experience as members of the permanent staff, pay no benefits and thus, enhance the firm's revenue and profit margin.

Cost of living considerations.

Multi-office firms located in cities and geographic regions with differing cost of living standards are compensating their associates at levels that are consistent with the cost of living standards of the city or area that the firm's offices are located. For example, if a firm has offices in New York City and Philadelphia, associates in the New York City office would typically be paid more money than comparable associates in the Philadelphia office.

Incentive compensation.

Hours worked: This is a useful measure for paying associates, as well as easy to calculate. However, paying for hours worked may encourage padding of hours. It has been our experience that certain clients ask if law firms pay any incentive compensation to associates based upon hours worked prior to engaging the firm.

More firms calculate hours worked incentives on the basis of hours actually billed as opposed to billable hours reported. This enables the firm to retain some control over billings to its clients.

Merit (based upon a combination of objective and subjective factors): Associates in more firms are interested in seeing their increases tied to their performance, rather than in lockstep progression. Partners in several firms reported better results by tying associate increases to their performance. As an interesting wrinkle, some firms are tying associate bonuses to firm performance. This takes the form of bonuses if the firm reaches a given level of financial performance.

New Business: A great many firms today do not progress associates to partner status unless they demonstrate the ability to originate business. In those firms that follow this practice, associates understand that their career development as well as their compensation is based upon their ability to generate business. Three concerns relating to new business incentives raised by partners in those firms that have implemented these program include the need to ensure that: the firm has a well-conceived and implemented client conflict and matter intake procedure; the firm has a good system for assigning substantive work to ensure that the new matter is performed by the most appropriate individual, not necessarily the associate who brought the client through the door; and the incentive compensation must be designed so as not to reward work on the associate's own matters to ensure that the associate will work on firm matters, not primarily matters that he or she originates. To accomplish this, the firm must analyze a combination of hours and the individual who generated the hours on the matters.

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